§ Direct Costs of Bankruptcy
§ The bankruptcy code is designed to provide an orderly
process for settling a firm’s debts, however the process is
still complex, time-consuming, and costly
§ Outside experts are costly (legal and accounting experts,
consultants, appraisers, auctioneers, etc.)
§ Lehman Brothers Bankruptcy reportedly entailed fees of $2.2
billion
§ Direct Costs of Bankruptcy (cont.)
§ Creditors may also incur costs (separate legal
representation and professional advice)
§ Studies typically report that average direct costs of
bankruptcy are 3~4% of pre-bankruptcy market value of
total assets
§ Firms can avoid filing for bankruptcy by first negotiating
directly with creditors - workout
§ Indirect Costs of Bankruptcy
§ While difficult to measure accurately, often much larger
than direct costs
§ Loss of customers / suppliers / employees / receivables
§ Fire Sales of Assets
§ Inefficient Liquidation
§ Armin Industries: The Impact of Financial Distress Costs
§ All-equity financing: Armin will be worth $150 million if the
new product is successful and $80 million if it is not
§ Debt of $100 million: Armin will be forced into bankruptcy
if the new product fails
§ In this case, some value will be lost to bankruptcy and
financial distress costs, and debt holders will receive less than
$80 million
§ Armin Industries: The Impact of Financial Distress Costs
(cont.)
§ Assume debtholders receive only $60 million after
accounting for the costs of financial distress
§ Who Pays for Financial Distress Costs?
§ The financial costs reduce payments to debt holders when
the new product has failed
§ But debt holders are already aware of this possibility –
therefore, they pay less for the debt initially (PV of
bankruptcy costs)
§ This difference is money out of the equity holders’ pockets
§ We can now combine our knowledge of the benefits of
leverage (Chapter 15) with the costs of financial distress to
determine the amount of debt that a firm should issue to
maximize its value
§ This is called the trade-off-theory (interest tax shield
against costs of financial distress)
(Interest Tax Shield) (Financial Distress Costs)
LU
V V PV PV=+ -
§ The Present Value of Financial Distress Costs
§ Three key factors
1) The probability of financial distress
• Increases with leverage and volatility of a firm’s cash flows and asset
values
2) The magnitude of the costs if the firm is in distress
• Likely to vary according to industry
3) Appropriate discount rate for the distress costs
• Depends on the firm’s market risk
§ Optimal Leverage
§ With low levels of debt, increase in leverage increases the
interest tax shield. If there are no financial distress costs,
firm value will continue to increase until the tax shield is
exhausted (interest equals EBIT)
§ Costs of financial distress reduce the value of the levered
firm, which increases with the level of debt
